One Unconventional Monetary Policy That The Conventional Wisdom Ignores

Let’s play word association.  If I say, “unconventional monetary policy,” what is the first thing that comes to mind?   If you are like most pundits and economists, you probably thought about phrases like quantitative easing, operation twist, NGDP targeting, large-scale asset purchases, or ‘forward guidance’–the signaling of low, low future interest rates.  A Google search for “unconventional monetary policy,” gives results about unconventional ways to expand the money supply and lower real interest rates by lending out more money.

But there is another form of unconventional monetary policy that is so unconventional that it has never been done before in history.  And it has the exact opposite effect of everything listed above.  At the same time in 2008 when the Fed started “unconventionally” lending vast new quantities of money out to the banks, the Fed also started a new program to dramatically increase vast borrowing from the banks!   One hand lent while the other hand borrowed it all back.  The Fed borrowing from the banks is contractionary monetary policy and when the history of the Great Recession is written, this will surely be cited as one of the stupidest monetary-policy mistakes that we have been making.  For the first time in history, the Fed has been borrowing enormous amounts of excess reserves from the banking system and this has probably contracted the real money supply by increasing reserves.  The Fed got the banks to loan it money by paying interest on their excess reserves for the first time ever.

One of the great academic mysteries about quantitative easing (and similar conventional forms of unconventional monetary policy) is why it is so ineffective.  But surely one reason in this case is that quantitative easing has been working against the unconventional contractionary policies that have been increasing bank reserves.  Whereas pundits and economists are gushing with advice about whether to expand or contract quantitative easing, hardly anyone ever suggests that the Fed should stop paying banks to hoard excess reserves.  Google News has 19,400 results for “quantitative easing” which is only one of the many conventional forms of unconventional monetary policy, versus only 575 results for “excess reserves.”  And almost all of the Google results about “excess reserves” are red herrings because they don’t mention the radically unconventional Fed policy of paying interest on them.  Nobody is talking about it.

Bloomberg’s Max Raskin and Joshua Zumbrun wrote one of the few articles about it and they estimated that:

The Federal Reserve could pay more than $77 billion a year in interest on the excess cash reserves it holds for commercial banks…

“Essentially the Fed paid the banks $4 billion last year, which is about $12 per American,” David Howden, a professor of economics at Saint Louis University’s campus in Madrid, Spain, said in an e-mail.

Howden analyzed interest on reserve payments so far for the [conservative] Ludwig von Mises Institute…

“If your bank called you up and said you have a new service fee of $12 because they screwed up in the crisis, you’d be livid, but that is basically what they are doing and no one knows about it.”

Ending excess reserves should be a no-brainer that both conservatives and liberals can agree upon.  Conservatives should like it because it would be a return to our traditional policy with a long experience of safety and prudence.  And it is an alternative to the kind of stimulus that their liberal opponents tend to propose: increased government spending.  Liberals should like it because it could help the poor and reduce unemployment.  Populists on both the right and the left should like it because it would eliminate a huge government subsidy that the Fed has been paying to pad the record profits of elite banksters.  Fiscal conservatives should like eliminating the subsidy because it would help reduce the federal deficit.  The only possible drawback is increased inflation, but the conservative market monetarists are right that the Fed should increase inflation because it could help stimulate economic growth and reduce unemployment.

A lot of economists have been surprised that five years of quantitative easing have failed to spark inflation.  Some economists have gone so far as to argue that this demonstrates that the Fed is unable to increase inflation.  This seems ridiculous given that every poorly-managed central bank in every 3rd-world banana republic has always been able to increase inflation even without trying.  The Fed has never stated that it has any interest in increasing inflation and the Fed shows that it isn’t really trying because it is paying interest on reserves to keep inflation down.

Whereas excess reserves have been a target for criticism from inflation hawks, unemployment hawks have mostly been silent about the matter.  Thus, most of the few people who are discussing excess reserves are complaining that reducing them might increase inflation and there is little push-back from people who want Fed policy to focus more on reducing unemployment and increasing economic growth.

If the Fed cared more about unemployment than inflation, it could do a simple experiment to see who is right about inflation and excess reserves.  Reduce the interest payments to the banks (which ultimately reduces a burden on taxpayers) and see if it does anything to increase inflation and/or reduce unemployment.  Nobody could even call it a risky, unconventional action, because it would merely be a return to longstanding normalcy.

Update:  Some central banks (like Sweden’s) went with the opposite policy and started charging banks interest on their reserves instead of paying interest.  In effect, they have been taxing banks for keeping money out of circulation to try to expand the money supply.  It hasn’t had a huge effect because they are only charging tiny interest rates, but even tiny amounts can help a little.

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